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Counterpoint – Share options – Accounting for share options

DAVID CREED, Director general, Association of Corporate Treasurers

Share options are an increasingly common way of rewarding employees – but how should they be accounted for? In this Counterpoint debate, we asked Andrew Given, FD of Logica, and David Creed, director general of the Association of Corporate Treasurers, to each write an article setting out their stance on this complex issue. We then gave Given’s article to Creed, Creed’s to Given, and invited them to write a short response to the other’s piece. Given, drawing on his experience at a FTSE-100 high-tech company, criticises the ASB’s proposals while Creed presents an intellectually rigorous argument for a new financial performance statement.

Share options are an increasingly common way of rewarding employees – but how should they be accounted for? In this Counterpoint debate, we asked Andrew Given, FD of Logica, and David Creed, director general of the Association of Corporate Treasurers, to each write an article setting out their stance on this complex issue. We then gave Given’s article to Creed, Creed’s to Given, and invited them to write a short response to the other’s piece. Given, drawing on his experience at a FTSE-100 high-tech company, criticises the ASB’s proposals while Creed presents an intellectually rigorous argument for a new financial performance statement.

Treasurers may not have a professional basis for a view on the accounting of employee share options, but they are familiar with share options through their management of a company’s capital base. When a treasurer is unsure whether to recommend to his board that funds are raised through the issue of a debt or equity instrument he may instead recommend a convertible bond – in effect, a fixed-coupon bond with embedded rights enabling the investor to surrender the bond in return for shares.

The embedded option has a market value at the time of the bond’s issue that will depend on the fixed conversion terms. This value is expressed through a reduction in the annual coupon payable on the bonds (the higher the reduction sought in the coupon the more attractive must be the conversion terms of the bond). One of the treasurer’s jobs in recommending a convertible is to ensure that the net present value of the coupon reduction over the expected life of the bond prior to its conversion is as close as possible to the market value of the call option granted within the bond over the company’s shares. This is complicated by the assessment of the expected life of the bond: the more rapid the rise in a company’s share price and annual dividend payments the earlier the bond holder is likely to convert the bond into shares.

In carrying out this assessment the treasurer is aware that the coupon reduction will be evident in the company’s p&l account as a cost reduction, whereas the loss of value to the company’s shareholders is an unaccounted possible opportunity cost – the cost of having to issue new shares at less than market price.

Of course, the bonds may never be converted because the share price does not rise through the option strike price, in which case the coupon reduction is a “free” gain in the company’s accounts. Naturally we know it is not really a free gain any more than an insurance premium is a free gain to an insurer that has no claims presented to it on that policy.

For treasurers, matters are complicated because a convertible bond may be issued instead as two instruments: a straight bond plus a warrant entitling the holder to buy shares at a fixed price by surrendering the bond. Suppose the bond is worth £100 at maturity after 10 years. It may be issued for a sale price of £100 for the package of bond and warrant together. Treasurers do not claim that the bond is worth £100 and the warrant worthless. In practice a market value is put on each instrument, say £90 for the bond and £10 for the warrant. The p&l account is debited with the coupon on the bond plus an annual amortisation over the bond’s life of the £10 original issue discount.

Together these two costs equal the coupon that would have been paid on a straight bond with no warrant. Under UK GAAP the £10 of value ascribed to the warrant is taken to reserves as shareholders funds. If the warrant is exercised by surrendering the bond the £10 is accounted as part of the capital raised in the share issuance. If the warrant is abandoned unexercised the £10 is reversed through the statement of total recognised gains and losses (STRGL) as a gain.

Although the economic impact of the warrant and bond structure may be identical, pre tax, to the convertible bond for both issuer and investor, the two approaches are accounted for differently – but this does not stop the treasurer ensuring that full value is achieved for shareholders whichever form is used.

The bond and warrant structure enables an enhanced tax deduction to be achieved through the deductibility of the amortisation of the bond’s original issue discount, making this the economically preferred route. This gives a tension for a company’s management in choosing the structure to be used – the one that has accounting benefits or the one that has tax benefits?

This serves as a background to a consideration of the accounting for employee share options. Clearly both the company and the employee think that the granting of an option transfers value from one to the other – the company hopes to get tangible and intangible benefits from a harder working, more loyal and dedicated workforce, the employee aims for financial gain by selling the shares bought through the option for a profit. This is like the issuer and investor in a convertible bond. The accounting problem arises because the gain (better working employees) is a company benefit but the cost is borne by the shareholders in giving away a free option.

To account for these options, a new performance account – the shareholder account – is needed, separate from the p&l and STRGL, showing gains and losses from management’s stewardship of the company’s share base. (This is the statement that would naturally show the gains and losses made from buying in and reissuing treasury shares when new legislation allows UK companies to so.)

Accounting needs to split away the interest and employment costs from the associated option cost and benefits. In the same way that a convertible bond, split into its component parts of a bond and warrant, achieves an accounting clarity, so should the employee share option. In either case the interest charge or the cost of employment should be added to by amortising the value of the option granted over the period during which the option grant generates value in the company (ie by a lower coupon or more effective employee behaviour). The corresponding credit is to the shareholder account.

If the option expires worthless the shareholder account shows a permanent gain. If the option is exercised the difference, between the market price on exercise and the exercise price, is a debit to the shareholder account, with the company’s balance sheet showing the shares issued at their market value. If this debit exceeds the initial credit the exercise, from the shareholder account perspective, has been a burden to shareholders, if not a net gain has been made.

Of course the issue of options may be beneficial overall despite a shareholder account loss: employees may be so much more effective that productivity incentivised by options gives a boost to the p&l, or investors in the convertible bonds may be encouraged to support the share price by buying shares, but it is not the job of accounting standards to measure these effects.

It is unacceptable to say that for options, since they are conditional, they have no value. Employees and investors do value them, and so does the market. Options are a cost, but one borne by shareholders, not the company. Nevertheless they must be accounted in a way that shows how value has been created and destroyed. Today’s accounting conventions are failing not just shareholders but their company managers as well.


I want to focus very tightly on the key issue of accounting for share options rather than endeavour to persuade the ASB to introduce yet another performance account.

Although by calling for a new performance account between the p&l and the STRGL Creed implicitly recognises that the p&l is not the place to show the impact of options since he identifies options as a matter between the shareholders and the option holders.

David Creed very specifically says in his article that “options are a cost, but one borne by shareholders, not by the company”. I don’t think that it is in dispute that they are indeed a cost – there is indeed no free lunch.

However, having agreed with me that they are a cost to be borne by the shareholders, not by the company, it is simply perverse to then conclude that for accounting purposes the cost should be shown as being borne by the company.

Opportunity cost they may be – but for the shareholders, not the company: and isn’t starting to account for opportunity costs the top of a dangerously slippery slope?

Creed and I can agree that we do need to account for options – and we obviously agree that the ASB’s proposals are not the answer. But please spare us from another performance account.

ANDREW GIVEN, Group FD, Logica

In attempting to tackle the real issue of accounting for share-based payment the Accounting Standards Board and its international brethren (excluding the US) have fallen into fundamental error. In summary they propose that the ‘cost’ of options should be a cost to the company and offer two alternative ways of computing the cost: (a) a Black-Scholes-based computation at the date of grant to value the option per se; or (b) the difference between the grant price and the price at vesting estimated and adjusted periodically over the period to vesting.

The primary issue is, should there be a charge at all? The arguments against this proposition are absolutely overwhelming on accounting, practical and macroeconomic grounds.

On accounting grounds there are no arguments in favour of the proposition. There can’t be, because the cost is to the shareholders, not to the company.

The transfer of economic benefit (the ASB’s definition of a cost) is between the option holders and the shareholders. The company acts as the shareholders’ agent but it does not bear the burden. To adopt any other position flies in the face of the ASB’s own fundamental logic.

The economic substance of the transaction is that the shareholders give up a proportion of their ownership in the hope that the smaller proportion that they will own will in future in aggregate be worth more than their undiluted interest due to the incentivisation given to option holders.

From the company’s perspective there is absolutely no discernible impact. From a practical viewpoint, companies which have substantial option programmes, if their share prices are volatile would have to report material impacts.

Given that this is inherently unforecastable, analysts would inevitably exclude these costs from their projections and analyse actual results against their forecasts – hence aligning themselves with companies who would inevitably also exclude these costs in the analyses they present.

Thus there would be a strong tendency for the information to be ignored and the ASB would have missed a legitimate target. Individual shareholders, too, would have further reason to be confused with yet another version of profits being discussed and presented.

On the other hand, the formal accounts would still include this data and for many companies with sharply rising share prices this could result in weak reported financial performance and in many cases losses – amplified at the after-tax level since the cost would not be deductible. For companies where financial strength is part of the selling proposition (particularly in formal bid documentation) this would make it actually harder to sell – a particularly damaging situation for smaller companies. This would be directly adverse to shareholders’ interests.

At the macroeconomic level the Americans have made it clear that they will stand aside on these proposals, having been bloodied in earlier attempts to address the issue. The companies that make extensive use of options are typically high-growth companies with high added-value through being intellect-based. Such companies represent the future for post-industrial economies as it is in this arena that they have comparative advantage.

The corollary of the concentration on intellectual capital is that they are relatively mobile and if the US has stood aside there would be an inevitable tendency for capital and companies to flow to the US, thus making the UK economy less competitive in precisely the area where we should be concentrating.

Even if the US did not stand aside, the effect of greater volatility of reported earnings – often, as noted above, with reported losses – would inevitably raise the cost of capital to such companies and this would adversely affect their ability to raise capital. This would inevitably slow down the growth of those companies upon whom the economy is most dependent for its future.

Reading some of the articles and correspondence on this issue which have appeared in the serious press and journals, there is a clear flavour that this is another “fat cat” issue.

This fundamentally misses the point. In companies where this is or may be an issue, the number of people to whom options are granted are generally small, and however large the individual gain the p&l impact of the ASB’s proposed treatment would be unlikely to be material.

Those companies which would be materially affected – the intellect-based ones – are in fact those that spread options widely through the organisation.

Such companies would inevitably feel pressure to reduce option grants and there would be a real risk that it would be the ordinary member of staff who would feel the draught. The ASB should also take note of the fact that it is UK government policy – regardless of party – to encourage equity participation. Helping people to gain a stake in their employer, the economy and society is a worthwhile end in itself.

There is a real issue with share options as current accounting standards do give the impression that options are a free lunch. However, the ASB’s solution is simply wrong. There is a better and simpler solution which addresses the heart of the issue, which is that this is a matter between the shareholders and the option holders.

The current FRS14 Earnings per share should be modified so that all potentially issuable shares under option arrangements are treated as being in issue (with an appropriate adjustment to interest income/expense) for the purposes of computing earnings per share and that this fully-diluted earnings per share number should be the primary one for reporting purposes.

Shareholders will clearly see the dilution to which they are exposed, but the company will be unaffected – which is the commercial and economic reality. This is exactly analogous to a rights issue at a discount: the company is not affected by the discount and reports accordingly but for shareholders earnings and dividends per share are restated to eliminate the effect of the discount and the apparent dilution.

The ASB needs to recognise that it has got it wrong and address the issue in line with commercial reality.


I agree with a number, but not all, of the points made by Andrew Given.

However, in his last but one paragraph, he sadly appears to lose his way completely. Options are wholly unlike rights issues at a discount.

Rights issues are made to existing shareholders: that is why the discount is not a cost. Options are made to third parties, that is why there must be a way of valuing the cost to – we are both agreed it is a cost – and the benefit received by, the existing shareholders for the option grant.

Relying on fully-diluted EPS as a measure misses the point. The value foregone (ie, the value of the option) can be measured either before option exercise (ie, at grant or vesting – both approaches have merit) or at exercise.

The first is an estimate by the market of what the option is worth, the second the true loss of value foregone by shareholders through a share issue at below market price.

What the benefits have been cannot always be determined accurately for employee options, but it must be attempted as part of good shareholder reporting practice.

How else is management supposed to measure what they are doing and how else should they be judged in their option awarding decisions?

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